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I’m Worried

April 10, 2012

I debated with myself about what to send as this week's Outside the Box. I have decided on a recent short but important post from my friend David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors. He calls it "I'm Worried." There are some very thought-provoking ideas here, but what makes it particularly interesting is that I'm running into this sentiment more and more as I travel around the US; and when I'm abroad I also hear from people who are worried about the US. These are folks who rightly realize the world needs a strong US, both as an economic engine and as a leader – a chairman of the board, if you will – of a growing world. (Can the world grow and prosper without us? Of course, but not as easily, and the transition will not be pretty.)

So this "worried" theme is one I hear, read, and see firsthand more and more each passing week. It's that gnawing feeling that things are just not going right and that our leaders are simply not up to the task of setting the ship on a steady course, even as they almost universally acknowledge we are on the wrong course and assert that the deficit must be dealt with. As with David, this concern is most vivid for me at the close of the day as I review my own thoughts and think on the future of my family and friends.

This deficit of ours is the single most important political and economic question of our time. How we address it, or fail to address it, will set an economic course that can once again turn vibrant and hopeful, or one in which we find ourselves sideways to some monster waves, and capsize. We watch Greece and Spain and worry as we look askance at our own fiscal situation and wonder whether we will be able to kick the can around the deck for "just one more year," before our ship is on the rocks. There is a growing sense that the last one more year may be fast approaching, through the fog. Europe is already there. Can our own denouement lie very far ahead?

I have known Kotok for the better part of a decade now. Mostly, he is a quite bullish and optimistic fellow; and, as he notes, he is fully invested in his client accounts and has caught the latest ride. He organizes the annual Maine fishing trip that has become quite the gathering of economists and writers. There, he has often chided me in the wonderful Maine evenings for what he perceives as my bearish views, although last year with Nouriel Roubini there I was at least not the most bearish of the group.

My main view, say a 60% probability, is that we do in fact deal with the deficit here in the US in 2013. I will enjoy becoming bullish once again and telling my kids to look to the future with hope. But like David I am worried. What should be just a bump in the road for the US and the free-market world can become mountainous if we do not face the real problems before us, if we do not recognize that "We have met the enemy, and he is us."

I choose to remember that David, in his brighter moments, is not quite so brooding. A good night's sleep may help. And yet, he voices a concern that is moving from the backs of our minds to the forefront with increasing urgency, across the full political and social spectrum. The drumbeat is becoming insistent that something must be done, and soon.

(You can read more of David's commentaries at www.cumber.com.)

I was in New York last Wednesday, and Tom Keene of Bloomberg TV was kind enough to invite me on his show for an extended interview and thoughtful exchange, not the usual two-minute drill. You can see that interview on johnmauldin.com. The link is on the left side of the page.

Have a great week. I think I will write to my friend Louis Gave and tell him to send me something bullish for next week's Outside the Box. I can usually count on him to find the silver lining. And now if someone can just arrange for some sun in San Francisco this weekend, I am sure I will get more positive about the world. David, maybe we should invite Louis to Maine to perk us up?!

Your really believing we Muddle Through analyst,

John Mauldin, Editor
Outside the Box

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I'm Worried

A note to readers. This 2000-word commentary is a longer-term view; think in terms of years, not months or days. The essay is not in conflict with the fully invested position currently held at Cumberland. The words reflect my personal thinking only. Some of my colleagues disagree. In my personal view, the future is uncertain (of course) and may be unattractive for the longer-term outlook. In my view, our American political system is failing us. In my view, we are joining the list of declining world powers. The framework to support that argument follows.

"The external menace 'You'll end up like Greece, if you do not do this and that' and the internal opprobrium heaped on some categories of taxpayers are very powerful and dangerous instruments to deprive people of their own personal freedoms." –Vincenzo Sciarretta

My friend Vincenzo is a journalist from Italy. He is a serious writer and researcher. He has covered the financial markets and economy of Italy for years. He and I co-authored a book on Europe during the optimistic period. If he and I were to write such a book now, it would probably be quite pessimistic.

Vince responded to my recent email series about the downward spiral underway in the euro zone. Readers may find those essays at www.cumber.com. Vince noted my reports from the meetings in Paris and my reference to the upcoming French elections, where the promise of the Socialist candidate is to raise the tax rate on the highest income level to 75%. I will end this commentary with a longer email from Vince, in which he quotes historian Will Durant and discusses the fall of the Roman Empire.

Now to write some thoughts that gnaw at me in the late of the night, when sleep is elusive.

Simply put: I'm worried.

When I get worried, I read and re-read in my library. I can honestly say that I have had my nose in a thousand of those books. The library holds many texts by giants. They wrote about history, economics, and finance. They took the strategic view. George Akerlof, Jared Diamond, Niall Ferguson, Carmen Reinhart & Ken Rogoff, Robert Shiller, and Nassim Taleb are among the modern writers. Milton Friedman, Martin Gilbert, Friedrich Hayek and his polar opposite John Maynard Keynes, Ludwig von Mises, R.R. Palmer, and Adam Smith are among the classics.

A favorite of mine is Paul Kennedy. Twenty-five years ago, this Yale historian concluded his monumental work The Rise and Fall of Great Powers with a profound observation:

"In the largest sense of all, therefore, the only answer to the question increasingly debated by the public of whether the United States can preserve its existing position is 'no – for it simply has not been given to any one society to remain permanently ahead of all the others, because that would imply a freezing of the differential pattern of growth rates, technological advance, and military developments which has existed since time immemorial."

Kennedy then argued that the United States has the ability to moderate or accelerate the pace of decline. Such is also the case for other great powers, many of which are in a state of decline from their centuries-old power peak. Among others in his treatise, Kennedy's history lessons examine Spain, France, Rome, and the Austro-Hungarian Empire.

I think I just covered a lot of the euro-zone geography.

In 1987, Kennedy warned us, "The task facing American statesmen over the decades, therefore, is to recognize that broad trends are under way, and that there is a need to 'manage' affairs so that the relative erosion of the United States' position takes place slowly and smoothly." He added the additional warning that it not be "accelerated by policies which bring merely short-term advantage but longer-term disadvantage."

Unfortunately, America's leadership has not heeded such warnings.

For decades futurists have complained about the rising use of government debt financing by the United States. They predicted calamitous outcomes, which did not arrive as expected. Paul Volcker and Alan Greenspan applied monetary policy in ways that allowed inflation and, hence, interest rates to spend a quarter century in decline. The Volcker-Greenspan era opened with the highest interest rates since the Civil War. Building on this downward momentum, Ben Bernanke has taken the target short-term interest rate to near zero and held it there.

During the same three decades, the US altered its fiscal policy, first under Ronald Reagan and almost continuously since. (The Clinton administration was the exception.) Rising deficit financing has been facilitated by falling nominal interest rates. That combination leads to level, or even falling, aggregate debt service. You can owe more and more and have smaller and smaller monthly payments. That is the magic of falling interest rates. Until they hit the zero boundary.

What happens when the music stops and the chairs are full? Are we reaching that point in the United States? It appears we have done so in Europe, certainly in Greece, the eldest of the declining great powers. We are also getting there in Japan and the UK. All four confront similar financial straits: zero-bound interest rates coupled with expanding national government debt.

About 85% of the capital markets of the world trade by means of the dollar, yen, pound, and euro. The G-4 central banks have collectively expanded their holdings of government securities and loans from $3.5 trillion to $9 trillion in just four years. At the prevailing very low interest rates, the functioning of monetary policy and the role of fiscal policy merge. Is there any difference between a million-dollar suitcase of one hundred dollar bills and a million-dollar, zero-interest treasury bill? You need an armed guard to protect the first one. With the second one, you need to clear an electronic trade in a safe financial institution, not an unsupervised (no more Fed surveillance) Federal Reserve primary dealer like MF Global. Your earnings on either the cash or the T-bill are the same: you earn zero. You can use the treasury bill to secure a repo transaction at a near-zero interest rate. You can use the cash to conduct many types of black-market or gray-market trades. Is it any wonder that the hundred-dollar bill is so popular? Isn't it understandable that roughly two-thirds of US currency circulates outside the United States?

Is this a healthy situation? How long can it persist? What happens next? When interest rates eventually rise, what will be the result of this blend of monetary/fiscal policy as its unwinding turns malignant?

Moreover, who then will be the politicians that inherit this mess? Who will occupy the central banker's chair?

I worry because there is no rationally explained strategic-exit plan in the G4. Not in the US. Not in Japan. Not in the euro zone. Not in the United Kingdom.

I also worry because the direction of taxation is up, if certain politicians continue to have their way. I worry because US business tax rates are now the highest in the entire world. In addition, I worry because of the increasing power that national governments wield in the mature economies of the world.

Applied power eventually leads to serfdom.

Increasing taxation is a characteristic of a declining great power.

Governments are failing to heed Paul Kennedy's warnings. They are worsening the longer-term outlook. The Western world's leaders ignored Kennedy when he wrote "… accelerated by policies which bring merely short-term advantage but longer-term disadvantage."

Zero-bound interest rates are a short-term advantage. We enjoy them. We profit from them. We expect them to continue for a while. They are like the oxygen administered to a very ill patient. If the patient dies, the oxygen has eased the pain in the terminal phase. If the patient lives, the lungs have been scarred and need many years of healing and repair. Today, the patient is receiving oxygen in the G4. Death is being delayed (Greece) or, perhaps, thwarted (elsewhere in the euro zone, Japan, US, and UK).

We do not know how this will play out. History only warns us that many of the likely outcomes may be unpleasant. The authors I cited have articulated their differing and diverse views. Their conclusions have tended to be in the form of warnings.

Paul Kennedy favors candor. In his second, exquisite work, Preparing for the Twenty-First Century, he wrote: "Many earlier attempts to peer into the future concluded either in a tone of unrestrained optimism, or in gloomy forebodings, or (as in Toynbee's case) in appeals for spiritual revival. Perhaps this work should also finish on such a note. Yet the fact remains that simply because we do not know the future, it is impossible to say with certainty whether global trends will lead to terrible disasters or be diverted by astonishing advances in human adaption."

Of course, we hope for the latter and worry about the former. History gives us little comfort.

For the time being we shall remain on the sanguine side with regard to this global experiment with increasing debt, zero-bound interest rates, and a monetary/fiscal policy compromise that obfuscates the difference between them.

As long as this persists, it means financial markets do well, stocks rise, risk assets regain favor, bonds with hedges yield results, and cash continues to earn zero return.

That is now. It may change tomorrow, next week, next month, next year or not for quite some time. There is no way to know.

For the downside from history we return to Vincenzo's email to me:

"Dear David,

"I invite you to read the last few sentences of the below article from The Lessons of History, by Will and Ariel Durant. It is about how the destruction of the Roman Empire through the taxation channel made people 'slaves,' in other words how serfdom emerged. This is my number one fear for Italy, but I guess France is making the same mistakes, just starting from a lower debt level. You can also find an online version of the book, thanks to Google.

"Rome had its socialist interlude under Diocletian. Faced with increasing poverty and restlessness among the masses, and with the imminent danger of barbarian invasion, he issued in A.D. 3 an edictum de pretiis, which denounced monopolists for keeping goods from the market to raise prices, and set maximum prices and wages for all important articles and services. Extensive public works were undertaken to put the unemployed to work, and food was distributed gratis, or at reduced prices, to the poor. The government – which already owned most mines, quarries, and salt deposits – brought nearly all major industries and guilds under detailed control. 'In every large town,' we are told, 'the state became a powerful employer, standing head and shoulders above the private industrialists, who were in any case crushed by taxation.' When businessmen predicted ruin, Diocletian explained that the barbarians were at the gate, and that individual liberty had to be shelved until collective liberty could be made secure. The socialism of Diocletian was a war economy, made possible by fear of foreign attack. Other factors equal, internal liberty varies inversely with external danger.

"The task of controlling men in economic detail proved too much for Diocletian's expanding, expensive, and corrupt bureaucracy. To support this officialdom – the army, the courts, public works, and the dole – taxation rose to such heights that people lost the incentive to work or earn, and an erosive contest began between lawyers finding devices to evade taxes and lawyers formulating laws to prevent evasion. Thousands of Romans, to escape the tax gatherer, fled over the frontiers to seek refuge among the barbarians. Seeking to check this elusive mobility and to facilitate regulation and taxation, the government issued decrees binding the peasant to his field and the worker to his shop until all their debts and taxes had been paid. In this and other ways medieval serfdom began."

Thank you, Vincenzo, for this serious response. Thank you Paul Kennedy for superbly articulating history and issuing clear warnings. Thank you, dear reader, if you are still with me. I hope I have provoked some thought.

Now we will seek another night's sleep and hope it is not elusive.

David R. Kotok, Chairman and Chief Investment Officer

Discuss This


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Michael Norton

April 15, 2012, 4:12 a.m.

We are presently headed for higher taxes and higher spending. So the fire extinguisher is charged with propane. It looks like Gov. Romney may be the one selected to lead a different approach to our problems, applying lower taxes, lower spending, or both. What concerns me is I am old enough to remember 1948. I lived in Chicagoland then; the famous “DEWEY BEATS TRUMAN” headline was delivered to our door. Gov. Romney is bright, articulate, a Washington outsider, and attractive. So was Gov. Dewey. Dewey never connected with “regular people”; Romney hasn’t yet. Is this going to be a 1948 redux?

claudia driver

April 12, 2012, 8:34 p.m.

” Faced with increasing poverty and restlessness among the masses, and with the imminent danger of barbarian invasion, he issued in A.D. 3 an edictum de pretiis, which denounced monopolists….”

There seems to be general agreement that things are bad on all sides of the political spectrum. It’s as easy to use history to prove a point as it is to use a sacred text - take your pick, the Bible seems rather useful in this country.

I’m no expert on the history of Rome, so I wonder what caused the increasing poverty and restlessness among the masses.

I read Kevin Phillips’ book Bad Money during the spring of ‘07 and found it very persuasive.

Jari Searns

April 12, 2012, 7:48 p.m.

The article by David Kotok is excellent and yes, extremely thought provoking; however, what is even more worrisome and thought provoking are the variance of the comments received in response to “I’m worried”.  There was a time in this country when we could reasonably (if strongly) disagree on a topic and have a reasoned debate to express a variety of points of view.  As we get closer and closer to the precipice of loosing a sound US economy, our voices are becoming more and more shrill and our reasoning is becoming weaker and weaker.  We no longer debate, we simply shout at one another.  How sad.

In short, it is a time to be worried…very worried!

Nelson Swanberg

April 12, 2012, 10:14 a.m.

What do we hear from other consevative voices? Don’t worry about the deficit, it is big enough to take car of itself. Ronald Reagan proved that deficits don’t matter. If you owe somebody 500 dollars you have a problem. If you owe somebody 1.4 trillion dollars they have a problem and the problem they have is making sure you have a vibrant economy that can service the debt or they run the risk of having a 1.4 trillion dollar bill handed to them. I understand George W. Bush’s picture is on that 1.4 trillion dolllar bill.

Mark Soderberg

April 11, 2012, 7:37 p.m.

Great writing…...Truer truths were never written.  I was especially touched by the part:
“Thousands of Romans, to escape the tax gatherer, fled over the frontiers to seek refuge among the barbarians. Seeking to check this elusive mobility and to facilitate regulation and taxation, the government issued decrees binding the peasant to his field and the worker to his shop until all their debts and taxes had been paid. In this and other ways medieval serfdom began.”
This part sure rings true and prophetic when we see the current attempts to control now….. the new Barbara Boxer (D CA) attachment to the congressional Bill that would give the IRS power to suspend/terminate ones Passport if unpaid taxes went unpaid…...a rather startling development in our advance to “serfdom.”

Don Braswell

April 11, 2012, 5:18 p.m.

Small correction (which may have occurred in the original):  Diocletian was a Roman Emperor from 284 to 305 (the last century before the 400 A.D. collapse) not in 3 A.D.  Augustus was the first emperors in 3 AD whilst the empire was expanding and gaining power.  The barbarians were always there - just in 3AD they were being forced back - by 300 A.D. they were pushing forward…

Alex Hammond-Chambers

April 11, 2012, 1:21 p.m.

I hate to oversimplify it but our malfunctioning democracies have induced poor political leadership based on promising prosperity beyond our means in return for political power.  Hence it is that living beyond our means becomes institutionalised.  Until we have some political leader - particularly one in the US - who is prepared to state that “he/she has nothing to offer but blood, sweat and toil ...”  There is no live-beyond-our-means-now-and-pay-later solution.  When we elect an Iron Lady because she says so, we will have started the recovery process.

Clyde Martin

April 11, 2012, 10:25 a.m.

I enjoyed the article, as I do all of the articles written by Mr Mauldin or reference articles. I do believe
conclusions drawn in this article are correct and the US and a major portion of Europe will be sliding
into the background of world affairs. Doesn’t this always happen to aggressor nations? This has been what the US has been throughout our history, we acquire by destroying our perceived enemies. The government controls the population by preying on fear! After all, this is how sheepies are controlled without the realization they are being led. But I digress.

Since the enactment of NATFA, I believe, we have been led quickly down the road toward a one world government. Actually the beings started with the United Nations, IMf and the list could go on and on. When will this actually take place, who can tell, all steps are small but in the same direction.
The carving out of the middle class in the US, I believe, was a planned and controlled program, what better way to make the mass of people defendant on the government?  Never believe what is in the media one must look 2, 3 or 4 possible moves down the road to see the expected path.

This entire post seems negative and with the thoughts there are conspiracies behind every tree, but this is not the point. The point is that history does repeat, leaders generally do not learn from history and therefore why spend our time and energies fighting at windmills? The game is rigged and the allusion is that we are able to change the direction of events. Leaders come and go, nations rise and fall. The question is: does this make a difference in the grand design of things? What is at issue is how we as persons/selves run our lives. Whether this government falls and is replaced by another is not relevant. The only thing that is relevant is how we conduct our selves in relation to other selves. Remove oneself from the circus and focus on what is really important. Realizing this main point at our time of death is to late.

Doug Pedersen

April 11, 2012, 8:01 a.m.

Great article - and terrific to see investment professionals thinking about history and the sweep of human change - because for truly long term perspective, it is this kind of liberal arts style thinking that we need.

Kennedy’s view is a good one - and it is clear that RELATIVE to its trading partners, the US standard of living is likely to decline.  This does not mean, as some on this thread think, that there must be absolute decline.  After all, even middle income Greeks, Romans and Spaniards live better today than middle income Greeks, Romans and Spaniards at their heights of empire.

I also think the US holds many, many advantages, not just geography, work ethic, and a legal system that generally respects property rights - the system may not be completely equitable, but you know the rules and can reasonably predict what will happen.

The article is right to put much of the risk on the POLITICAL system - where we increasingly focus on the short term: focusing on the next election and trying to kick the can down the road.  In Europe, where I live, we are watching the slow disintegration of the social democratic state.  It will be painful, because it is forcing many people to address the fact that they cannot have what they thought they could (economic stability, strong growth and strong protections negating the vicissitudes of life).  It turns out that the first is the enemy of the second, and without the second you can have neither the first or the third.

I have some hope that we will come to grips with our problems.  My scepticism arises less from looking backward than looking forward.  As countries age, they simply become less dynamic.  There is less risk taking among older people, who instead look to preserve what they have.  Among those things they strive to preserve with maximum vigor is the social safety net that primarily benefits themselves.  Old people take a short term view, mostly because they don’t have a long term perspective.  Boomers, insatiable narcissists, are likely to exacerbate this trend going forward.  Worse, Boomer politics consists mostly of trying to make the other guy wrong (which is easier than making yourself right).  It puts everyone’s attention on the other guy, leaving you free to hand out perks to your friends and family.  If your own behavior is indefensible, make sure you spend your time pointing out that the other guy is no better.  This is dysfunction - it is a soap opera or an episode of Rikki Lake.  It is not serious politics.

Look at the proposed “solutions” to the entitlement crisis: keep high benefits for existing retirees, (necessitating high taxes on current workers), but cutting the benefits on the same workers.  This is pretty much the first step to serfdom: you are tied to the payroll tax and forced to work 1 day a week on the old folks plantation.  They are busy with their leisure activities.

If there is hope, it is that a new generation of leadership is rising.  This generation, born after 1960, knows and has known for decades, that it was being set up to take the shafting for the insane benefits handed out to those who retired earlier.  But even the rising generation of political leaders: Paul Ryan, Chris Christie, Scott Walker, who are trying to address these challenges, and doing more than anyone has done before, are still mostly working at the margins, or are afraid to engage in a national conversation where EVERYONE (including current beneficiaries) has to make a contribution to pay the piper for the last 80 years of expanding government liabilities.

The crisis of social democracy is upon us, and whether and how we address it is the big political challenge of this decade (with a major “clash of civilizations” in the mid east and rising Asian powers as the foreign challenges).  But as Kennedy wisely tells us, an effective foreign policy can only be carried out by a country that has the economic means to produce, field and project military power.  Foreign crises will be both more probable and more intractable, with less favorable outcomes (at least for the US), if our economic house is not in order.

Jeff Ohlinger

April 11, 2012, 6:39 a.m.

“Increasing taxation is a characteristic of a declining great power.”

Apparently it is also a characteristic of a rising great power too.  US tax rates rose dramatically after the 1920’s and top marginal rates stayed extremely high well into the 60’s (and when lowered in the 60’s were still double what they are now).  Under those rates the US became the world’s great power.  Growth rates in the US under those rates were much higher than the growth rates achieved in recent decades with substantially lower rates (and the best growth of those decades came after the top marginal rate was raised!).

We’ve got lots of problems, but high tax rates isn’t one of them.

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